Contrary to common belief, an S corporation or “S Corp” is not itself a legal entity created under state law. Rather, S Corps are corporations (or LLCs) whose founders have filed a Form 2553 with the IRS electing to have the company taxed as a “small business corporation” under the federal tax code. When the company has been set up as a corporation, the decision whether to become an S Corp (by filing Form 2553) or a C Corp (by doing nothing) is one that has significant implications for the company in terms of its ability to raise capital and how much will be paid in taxes. In what follows, I’ll explain the advantages and disadvantages of becoming an S Corp, how to make an S election, and the requirements for approval.
S Corp Advantages
S corporations have a number of advantages over companies treated as disregarded entitles (i.e., LLCs with single founders) or companies that are being taxed as C corporations or partnerships. These advantages primarily relate to taxes, and include:
1. Pass-through tax at the corporate level. The company’s income and losses pass through to the company’s owners, and the company itself does not pay income tax on earnings.
2. Reduced self-employment taxes. This is a large subject deserving of its own article, but here it is in a nutshell. When you’re self employed, you pay both portions of Social Security and Medicare taxes to the government. As an S Corp, you can classify some of your income as salary and some as a distribution, and you’ll just pay ordinary income and not self-employment taxes on the salary portion. This is an opportunity to substantially save on the amount of self-employment taxes.
3. Simplified tax laws. On the whole, S Corp tax law is significantly simpler than partnership tax law, which can be exceedingly complex.
The decision whether to elect S Corp tax status depends on a number of factors that will be different in each individual circumstance. Therefore, this is a decision that should only be made after obtaining proper advice form a lawyer and a CPA or tax lawyer.
S Corp Disadvantages & IRS Requirements
As we’ve seen, an S election can have a number of tax advantages under the right circumstances. However, it can also have a number of drawbacks. As a general rule, if you intend on growing your business by seeking outside investment through venture capital and the like, you’re better off sticking with a C Corp. Specifically, the IRS has significant restrictions that a company must adhere to in order to obtain and continuously maintain S Corp status, and it is those restrictions in particular that often make S corporations unattractive to venture capital investors. These requirements include the following:
- S corporations must be domestic companies, meaning they must be incorporated in the US;
- Only individuals, estates, and certain trusts or certain tax-exempt organizations may be shareholders, and shareholders cannot include non-resident aliens;
- The company may have no more than 100 shareholders;
- There may be only one class of stock; and,
- The company must not be an “ineligible corporation”.
Because S corporations are limited to one class of stock, there’s only one kind of shareholder. Consequently, there is no hierarchy or difference between shareholders of the business, which makes fundraising difficult.
How to Become an S Corp
If the founders decide to have the company taxed as an S Corp, then they will need to file IRS Form 2553 within 75 days from the date the company was incorporated. Incorporation is accomplished by filing Articles of Incorporation or Articles of Organization with the Oregon Secretary of State.
If you are thinking about starting a business in or around Portland, Oregon or are interested in learning more about choosing the right business structure, contact us.